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DECLARATION OF KENNETH J. ARROW

I. QUALIFICATIONS AND INTRODUCTION

A. I, Kenneth J. Arrow, am the Joan Kenney Professor
of Economics and Professor of Operations Research at Stanford
University. I received the degrees of B.S. in Social Science
from The City College in 1940, M.A. in mathematics from Columbia
University in 1941, and Ph.D. in economics from Columbia
University in 1951. I have taught economics, statistics, and
operations research at the University of Chicago, Harvard
University, and Stanford University, and I have written more than
200 books and articles in economics and operations research. I
am the recipient of numerous awards and degrees, including the
Nobel Memorial Prize in Economic Science (1972). A significant
part of my writing and research has been in the area of economic
theory, including the economics of innovation and its relation to
industrial organization. My curriculum vitae is attached.

B. I had been asked by the Antitrust Division to
consult with them on the possible courses of action with regard
to Microsoft Corporation, before the filing of the proposed
Consent Decree. I have now been asked by them to comment on the
Memorandum of Amici Curiae against the proposed final judgment
offered by Gary L. Reback and others.

II. THE ECONOMIC RATIONALE FOR THE GOVERNMENT'S COMPLAINT

A. The Elimination of Artifical Barriers to Entry

The Government's complaint against and settlement with
Microsoft will eliminate artificial barriers that Microsoft had
erected to prevent or slow the entry of competing suppliers of
operating system software products for IBM-compatible PCs. The
complaint addressed certain practices associated with Microsoft's
MS-DOS and Windows operating system software products and the
successors to those products (specifically, the product code-named Chicago to be released as Windows 95).

Microsoft erected artificial barriers to the entry and growth of competing
operating system vendors through its contractual relations with original
equipment manufacturers of IBM-compatible PCs (OEMs). These practices
included the following: (i) contract terms that required OEMs to pay
Microsoft based on the number of computers shipped whether or not those
computers had a Microsoft operating system preloaded (the "per-processor"
contract); (ii) unnecessarily long terms for the contracts with OEMs
for the use of Microsoft's operating system software products; and (iii)
large minimum purchase obligations for OEMs ("minimum commitments").

Microsoft's contractual relations with OEMs had
created strong economic incentives for OEMs to deal exclusively
with Microsoft. OEMs with a per-processor contract were
obligated to pay Microsoft a royalty fee for every computer they
sold with a specified type of microprocessor (e.g., the Intel
486). The royalty had to be paid even if the OEM elected to load
an operating system on the machine from a different vendor. As a
consequence, OEMs who did elect to load competing operating
system software products had to pay a double royalty - one to the
supplier of the software actually used and a second royalty to
Microsoft.

The per-processor incentives for exclusive purchases
from Microsoft made it more difficult for suppliers of competing
operating systems to find willing outlets for their products in
the important OEM distribution channel. This barrier was
compounded by Microsoft's long contract terms and by the
inclusion of large minimum commitment obligations in the OEM
contracts. The long contract terms, along with the exclusivity
incentives of the per-processor contract, made it difficult for
OEMs to switch to an alternative supplier of operating system
software products. OEMs with a per-processor contract had a large financial incentive to
deal exclusively with Microsoft for the duration of the contract.

Large minimum commitments had an economic effect
similar to that of the per-processor contract. An OEM with a
minimum commitment has a "take-or-pay" obligation for the amount
of the minimum commitment. As in the per-processor contract,
this obligation can force an OEM into a situation where
purchasing from a competing supplier of operating system software
products would require the OEM to pay a double royalty. For
example, suppose the OEM had planned to sell 100,000 computers
and agreed to a minimum commitment with Microsoft for 100,000
units of MS-DOS. The OEM would face a financial penalty if it
purchased operating system software from another supplier and if,
as a consequence, the OEM's purchases from Microsoft fell below
the minimum commitment of 100,000 units. In that event, the OEM
would have to pay royalties to both Microsoft and the alternative
supplier for each unit that the OEM buys from the alternative
buyer.

B. Opening Access to the OEM Distribution Channel

A new competitor has to overcome the natural barriers
to entry that exist in many markets and especially the software
markets. The Department of Justice's complaint against Microsoft
and the resulting settlement eliminated unnecessary and
artificial obstacles erected by Microsoft to disadvantage future
competition. This action will not eliminate natural advantages enjoyed by
Microsoft which result from its own innovative activity and the
commercial success of the IBM-compatible PC platform.

Despite the importance of natural advantages (see
section III below) in the market for IBM-compatible PCs, the
complaint and proposed remedies addressed competitive issues that
are critical to the success of new competition in this market.
The most effective and economic point of entry for sales of IBM-compatible PC operating systems is the OEM distribution channel.
New operating system software products should have unimpeded
access to this channel. The Government's complaint and proposed
settlement provide needed relief to facilitate the entry of new
competitors, such as IBM's OS/2.

III. INCREASING RETURNS AND BARRIERS TO ENTRY

A. The Presence of Increasing Returns and Barriers
to Entry

The analysis of the Department of Justice and the
amici curiae brief agree that the software market is peculiarly
characterized by increasing returns to scale and therefore
natural barriers to entry. Large-scale operation is low-cost
operation and also conveys advantages to the buyer. Virtually
all the costs of production are in the design of the software and therefore
independent of the amount sold, so that marginal costs are
virtually zero. There are also fixed costs in the need to risk
large amounts of capital and the costs associated with developng
a reputation as a quality supplier. Further, there are network
externalities, in particular, the importance of an established
product with a large installed base and the related advantage of
a product that is compatible with complementary applications.

Installed base generally refers to the number of
active users of a particular software product. A software
product with a large installed base has several advantages relative to a new entrant.
Consumers know that such a product is likely to be supported by
the vendor with upgrades and service. Users of a product with a
large installed base are more likely to find that their products
are compatible with other products. They are more likely to be
able successfully to exchange work products with their peers,
because a large installed base makes it more likely that their
peers will use the same product or compatible products.
Installed base is particularly important to the economic success
of an operating system software product. The value of the
operating system is in its capability to run application
software. The larger the installed base of a particular
operating system, the more likely it is that independent software
vendors will write programs that run on that operating system, and, in this circular fashion, the more
valuable the operating system will be to consumers.

The large installed base of IBM-compatible PCs that
use Microsoft's operating system software reflects Microsoft's
dominance of that market and undoubtedly contributes to its
competitive advantage over competing operating system vendors.
One important question is the theoretical analysis of the
consequences of this advantage in a world of increasing returns.
In particular, it is necessary to ask to what extent, if any,
would government policy to interfere with natural advantages of
scale lead to an improvement from the viewpoint of the consumers. A
second question is the extent to which the anticompetitive
behavior complained of has in fact contributed to Microsoft's
dominance.

B. First-Mover Advantage and Increasing Returns

On pages 36ff. of the amici curiae brief, there is a
penetrating discussion of the role of increasing returns in
altering conclusions based on competitive markets with constant
returns. I have little disagreement with the bulk of the
statements made but do not agree with the implications for policy
that the writers of the brief draw.

It is correct that under strongly increasing returns,
the tendency of the market is towards monopoly. The brief does
not, to be sure, allow very much for the theoretically and
empirically very well-known possibility of imperfect competition.
Economies of scale need not lead to a single producer, though
they do lead to market power for the producers.

However, there is undoubtedly the possibility of monopolization, and it is
certainly possible that the monopolization is inefficient. But notice
that most of the steps in the dynamic process leading to monopoly or
imperfect competition are steps in which the growth of the monopoly
arises by offering a cheaper or superior product. As indeed the brief
emphasizes, the process is entirely natural in the market. On what basis
can a government intervene to insure a better outcome?

If monopolization is inevitable, as the amici's
argument, implies, then the outcome can only be criticized on the
basis that the wrong monopolist survived. We are dealing with a
complex system in which the outcome is not easily predictable.
Indeed, predictions in the whole modern history of the
information business have been very poor. AT&T did not realize
the consequences to it of the development of the transistor,
which eventually destroyed its monopoly. IBM was hesitant about entering the electronic computer industry altogether and failed
to understand the potential of PCs; otherwise, it would have made
a very different contract with Microsoft. Xerox developed the
basic ideas which developed into Apple and took no economic
advantage of them. This unpredictability is precisely what would
be expected of a complex self-organizing dynamic system. But it
also means that the government is not in a position to predict
either, and interference to pick the winner of this dynamic
process is likely to be counterproductive.

The amici curiae brief notes that, "once a market is
'tipped' in favor of a particular competitor, it would take truly
massive forces to return the market to a state of equilibrium
(i.e., competition)" (p. 40; italics added). There are two
remarks to be made here. (1) Clearly, competition is not a state
of equilibrium or at any rate not of stable equilibrium, as a
preceding quotation on the same page makes clear. (2) "Truly
massive" forces are very likely to impose their own truly massive
costs, which have to be weighed against the gain from
competition, which, under increasing returns, is sure to be
inefficient, or from "tipping" the equilibrium in the right
direction, which is usually unknowable.

To be more concrete, in this situation, any set of
remedies is likely to be of the form of penalizing whatever firm
happens to be leading, Microsoft in this instance. This may take the form of
disintegrating the firm horizontally or vertically or of imposing
constraints on its ability to enter certain markets. A rule of
penalizing market successes that are not the result of
anticompetitive practices will, among other consequences, have
the effect of taxing technological improvements and is unlikely
to improve welfare in the long run.

This is not to deny that a firm with a large installed
base or other realization of scale economies may sometimes be in
a position to impose artificial barriers, and these should be
regulated or prohibited, as the present proposed Final Judgment
already does. But interfering with purely natural barriers to
entry can be dangerous to the economy's welfare.

The amici curiae brief does in fact a good job of
presenting possible arguments for not going further in trying to
break up a natural monopoly (pp. 74-83): inevitability of
monopoly, entry by alliances, Microsoft's own self-interest in
competition in applications software, and the efficiencies of
integration. The brief attempts to refute these, but in my
judgment makes only small critical points.

C. Anticompetitive Conduct and the Present Installed Base

The brief makes much of the fact that Microsoft's
installed base has increased in five years from about 18 million
units to 100 million or more. It ascribes this growth to
anticompetitive behavior. It seems to conclude that even though,
given the installed base, there might be large real costs in
effecting changes, they should be made anyway, since the
installed base was itself the result of anticompetitive actions.

This conclusion appears flawed for a number of
reasons. Clearly, the six-fold growth in the installed base is
primarily the result of the extraordinary commercial success of
the IBM-compatible PC platform, in which MIcrosoft's product
development and marketing played a part. In such a situation of
rapid growth, the previous installed base should have provided a
relatively weak constraint on entry. For the most part,
Microsoft appears to have achieved its dominant position in its
market as a consequence of good fortune and possibly superior
product and business acumen.

It appears that the effect of Microsoft's OEM
licensing practices on its installed base is far less than
claimed in the amici brief. Microsoft's anticompetitive
licensing practices, although a significant impediment to the use
of the OEM distribution channel by competing operating system suppliers, made only a minor
contribution to the growth of Microsoft's installed base. Even
this minor contribution overstates the economic impact of
Microsoft's licensing practices on its installed base barrier to
the entry and growth of competing operating systems.

Microsoft first instituted its per-processor licensing
arrangement in 1988. However, this contract did not affect
enough of the OEM channel to foreclose competition until FY 1992, when 50% of all OEM sales of MS-DOS were sold pursuant to per-processor licenses. The corresponding number was 20% in FY 1989,
22% in FY 1989, and 27% in FY 1991.

The data on the fraction of the OEM channel affected
by Microsoft's anticompetitive licensing practices lead to the
inescapable conclusion that the per-processor contract did not
have a material impact on the installed base of Microsoft
operating system software. The complaint and proposed Final
Judgment address the effects of Microsoft's licensing practices
on future sales of competing operating systems.

In any case, increased sales of DR-DOS would not have
significantly affected Microsoft's installed base advantage. DR-DOS was marketed as an operating system software product that
was fully compatible with MS-DOS. Because DR-DOS supported the same
application program interfaces as did MS-DOS, application program
developers would have continued to write for MS-DOS (or Windows)
even if DR-DOS sales had been much larger.

D. The Transience of First-Mover Advantage and the Importance
of Open Markets

The history of market shares in PC application
software has been marked by great volatility. Although first-mover advantages and increasing returns are important, there are
many examples to show that such advantages are far from
permanent. As examples, consider the fates of Wordstar, Apple
Computer, and IBM itself. All were once dominant in critical PC-related product markets; yet each has experienced rapid loss of
market shares.

Noting this transience is not a justification for
complacency. On the contrary, it requires effort to maintain the
openness of markets, so that new technologies can have an
opportunity to enter and show their value relative to older ones.

Accordingly, the proposed settlement appropriately
addresses and remedies the anticompetitive effects of the
practices challenged in the complaint.

I declare under penalty of perjury under the laws of
the United States that the forgoing is true and correct.